Venture Far, Think Small

When you're traveling abroad, it's often the tiny town not listed in the guidebook that produces the most rewarding experience. That's the way it can be with foreign investing as well: Fund managers sometimes get the best returns by betting on smaller companies that are familiar only to the locals.

Journal Report

Unfortunately, most investors take a different approach when building their foreign exposure, especially in periods of increased volatility. They flock to funds that primarily invest in large, well-known companies.

But over the past decade, in developed markets outside the U.S., stocks of larger companies lost 3.1% a year on average, while those of small and midsize firms averaged a 1.2% annual gain, according to index firm MSCI Barrra. Shares of small and midsize companies in emerging markets averaged an annual 10% increase, compared with a 6.3% gain for larger stocks in those markets.

Growth Prospects

ENLARGE

Janusz Kapusta

Despite the strong run by shares of smaller firms based outside the U.S., as a group they don't appear overvalued: They trade for less than their historical average price/earnings ratio and ratio of price to book value. They also trade at P/E levels similar to those of larger foreign firms and are slightly cheaper than larger companies based on price/book ratio, according to MSCI.

With much of the global economy struggling, smaller companies may be an even bigger draw. An additional big customer or new service can have a sizable impact on a smaller firm's profits but barely move the needle for a larger company.

In addition, some smaller firms have commanding market shares in niche industries, providing some cushion against a sluggish economy. Smaller companies also are less affected by global economic forces; their share prices are tied more to company-specific factors.

Tapping New Consumers

Smaller companies are especially attractive to investors trying to tap into the economic growth of emerging markets like China or India. People in the early stages of consumerism typically spend their money in local markets where smaller companies often operate, says Carolyn Kedersha, portfolio manager of Boston Co. Emerging Markets Small Cap, a fund for institutional investors.

Smaller companies can offer a pure play on the growth of an emerging market's middle class, while big global companies typically get just a portion of their sales and profits from these new consumers, she says.

Further, because smaller firms often get most of their revenue in their home country, their stocks "are more important than large-caps for diversification," says Chris Cordaro, chief investment officer of RegentAtlantic Capital LLC, an investment advisory firm. Foreign-based multinationals tend to perform more similarly to large U.S. companies.

Smaller Is Riskier

To be sure, smaller companies are inherently riskier. Many are newer companies, which are prone to growing pains and sometimes have limited access to capital. And when financial markets are in turmoil, investors often dump assets that they believe are riskier—a double whammy for small, foreign stocks. Any declines can be exacerbated by the relative illiquidity of smaller stocks. To offset those risks, many fund managers look for companies with solid balance sheets and businesses that can survive financial-market crises.

Investors looking for small foreign stocks will find only limited exposure in most exchange-traded funds and mutual funds that hew to major foreign-stock benchmarks. But there are plenty of funds that focus on small and midsize stocks outside the U.S. Here's a sampling.

Matthews Asia Small Companies hunts for companies in Asia outside of Japan that have demonstrated growth potential but haven't attracted too much attention. "You want to capture them before they get too big or they become a noted story," to maximize gains, says fund manager Lydia So.

In Asia, small companies are often found in industries still emerging in some countries—from financial services to health care—which can translate into even more growth. Ms. So typically avoids capital-intensive industries like property development and utilities, because of debt concerns, and favors service-oriented businesses. In the past year, through June 30, the fund gained 42%, topping the Pacific/Asia ex-Japan category, according to researcher Morningstar Inc.MORN-0.13%

The fund was launched in 2008 by Matthews International Capital Management LLC, an old hand in Asia.

Fund manager Justin Thomson favors companies whose growth prospects he believes are underestimated by the market. Unlike some peers, the fund will hang on to a stock after it exceeds most small- and mid-cap parameters. Still, all but two of its holdings are under $10 billion in market value.

Japanese companies make up the biggest portion of the portfolio, at 17%. A pickup in merger activity also makes Europe attractive, Mr. Thomson says. In the past year, the fund rose 16%, putting it in the top half of its Morningstar category. Over three years it is in the top 30%, averaging an annual loss of 9.5%.

Vanguard International Explorer, on the other hand, has one of the smallest emerging-market stakes of diversified foreign small- and mid-cap funds, recently 11%. Decisions to invest in those markets often "represent macro rather than stock calls," says Matthew Dobbs, co-manager of the $2 billion fund. "We see our role as finding and investing in emerging companies, and there are plenty of those in developed markets."

That said, Mr. Dobbs favors companies in Asia (with the exception of those in Japan) and a handful of emerging markets like South Korea, China and India over the United Kingdom or Southern Europe. Recent purchases include a German menswear retailer and a Singaporean aircraft-maintenance firm.

The fund has lost an average of 12% a year over the past three years, putting it in the top half of its category, according to Morningstar. Its 13% gain in the past year puts it in the bottom third. But with an expense ratio of 0.45%, the fund is one of the cheapest international small- or mid-cap options available.

Harding Loevner International Small Companies sticks to developed markets, with half the fund invested in the U.K. or continental Europe. Lately, the fund has also been buying Japanese stocks, favoring industrials that don't require hefty capital spending.

The fund invests in companies with solid balance sheets—with operating earnings, for instance, at least three times their interest obligations—and an operating track record of at least five years. "The companies we look for may be a bit more boring but have high-single-digit growth and continually invest in it to improve operations," says co-manager Josie Lewis.

The fund tops the foreign small- and mid-cap growth category over the past three years, averaging an annual loss of 6.8%, according to Morningstar. In the past year it is up 24%, putting it in the top 5% of its category.

IVA International, launched in 2008, invests in everything from Singaporean bonds and gold to a smattering of giant multinationals. But co-managers Charles de Vaulx and Chuck de Lardemelle favor smaller companies, like French fragrance and flavor firm Robertet SARBT0.00% and Korean candy maker Lotte Confectionery Co. The median market capitalization of the fund's stocks is $1.3 billion.

The managers are veteran global investors who are known for their conservative style and proclivity for making contrarian bets and holding cash. The fund has a quarter of its assets in Europe and about the same in Japan, with 11% elsewhere in Asia.

The fund is up 13% in the past year, putting it in the bottom third of Morningstar's foreign small- and mid-cap value category. Since the beginning of this year it is down less than 0.1%, placing it in the top 6%.

Ms. Kapadia is a staff writer in Washington, D. C., for SmartMoney magazine. She can be reached at reports@wsj.com.

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